The present invention relates to diversified long term investing.
For centuries businesses have issued publicly traded securities to fund the business' operating capital or enable growth. There are two basic types of securities: bonds that represent debt, and stocks that represent ownership or equity interest in the issuing business. Bonds represent the promise of the business to pay a fixed sum at a specified maturity date plus interest at regular intervals until such date. There are numerous types of bonds such as convertible bonds, income bonds, or linked bonds. Stocks (or units) give an owner a right to a share of dividends and other distributions of the underlying business, to vote for directors and fundamental corporate changes, to inspect the accounting books of the business, and other rights defined by the charter and bylaws of the business as well as by the laws of the country or state in which it is chartered.
Overall, stock markets have provided an efficient way to raise capital. Performance of the entire market or individual market sectors may be monitored using different stock indexes. A stock index includes a selected group of stocks, wherein each stock affects the index in proportion to its relative weight. The relative weight can be selected based on market capitalization, market-share (i.e., number of outstanding shares), or price of the stocks. Thus, there are capitalization weighted indexes, market share-weighted indexes, or price-weighted indexes. Capitalization weighted indexes include NASDAQ Composite Index ®, S&P 500®, Wilshire indexes, Equity Index®, Russell Indexes®, and numerous other indexes. Price-weighted indexes include Dow Jones Industrial Average®, Dow Jones Transportation®, and Dow Jones Utilities®.
Stocks, bonds and numerous other financial instruments (e.g., derivatives, stock options, commodity futures or other options) can be held in various types of investment funds and trusts. An investment fund includes a portfolio of securities managed by a management company that serves as an investment adviser (and may also serve as a custodian, shareholder, servicing agent, transfer agent or provide some other secondary service). The management company or the investment advisor selects the financial instruments depending on the type of fund or trust. That is, there are various types of funds including stock funds (e.g., funds that invest in domestic or international stocks, growth or value stocks, small, medium or large capitalization stocks, etc.), bond funds (e.g., funds that invest in U.S government or foreign government bonds, mortgages, convertible bonds, low quality “junk” bonds, etc.), hedge funds, or funds that invest in two or more types of securities such as both stocks and bonds.
Mutual funds, also called open-end investment funds, have existed for decades. In a mutual fund, a shareholder owns a portfolio of financial instruments and receives dividends on the shares that he or she holds. Any day, a shareholder can sell or redeem any of its outstanding shares at net asset value (i.e., the price of a share equals total assets minus liabilities divided by the total number of shares) calculated at the end of a trading day. Similarly, an investor can also buy additional shares of a mutual fund, which in turn will invest the money. Thus an open-end fund can continue to increase its asset base by selling its shares to new shareholders and investing the influx of money in more shares.
There are “actively” managed mutual funds, where the advisor buys and sells securities based on his or her opinion about expected future performance. Here, the turnover ratio and thus the cost can be relatively high compared to index funds. There are also “passively” managed mutual funds where the fund advisor does not have much discretion and invests in a portfolio of securities that mirror a selected market index. Thus, in these funds, the cost is usually fairly low, but the funds have limitations related to the type of index followed, as described below.
Closed-end funds include actively managed or passive portfolios of stocks grouped according to an investment objective. Usually, after the initial sale, shares of closed-end funds are sold on a stock exchange the same way as stocks. Closed-end funds differ from open-end funds in that the number of shares is fixed. There are closed-end funds where a shareholder cannot exchange shares for underlying stock, which contributes to fluctuation of the price of the shares sometimes significantly above or below the net asset value. Low demand for a closed-end fund causes closed-end shares to trade at discounts to net asset value, and high demand creates premiums to the net asset value. In these funds, a shareholder cannot directly take advantage of the discount since he or she cannot exchange the fund shares for the underlying stocks. An investment advisor actively manages the fund, and the fund value (including any discounts or premiums) changes depending on the market conditions and skills of the advisor. Depending on the fund management, these funds may have a high turnover rate and thus high cost.
Passively managed funds are usually low cost, as mentioned above, because the advisor does not have much discretion to trade and thus does not have to have a team of highly compensated managers and analysts. There are numerous index funds that hold a portfolio of securities that mirror a selected market index. The advisor buys and sells the individual securities only when their representation in the underlying index changes, when investors redeem fund shares for cash or when investors purchase additional fund shares. These funds provide investment results that, before expenses, generally correspond to the price and yield performance of the index. As explained below, most indexes are heavily weighted toward large and midsize stocks. Furthermore, the indexes are periodically rebalanced, and the relative stock representation is reduced as a company grows and its stock moves from a micro cap index fund to a small cap index fund or to a mid cap index fund. Thus, the index funds do not effectively accumulate the best performing stocks because they are effectively sold as they move to a larger index fund.
Perhaps the oldest market index is the Dow Jones Industrial Average®. This index presently includes common stocks of 30 large companies. There are also other Dow Jones indexes such as the Dow Jones 20 Transportation Average®, or the Dow Jones 15 Utilities Average®, or the Dow Jones Composite Average®. The Dow Jones averages are calculated by adding together the prices of each stock's trading on a primary exchange and dividing the sum by a divisor, which is of course different for each index. The index divisor depends on the stock splits and is designed to maintain “continuity.” When a new stock is included, or corporate actions are taken (such as spin-offs, company purchases, stock splits, etc.), the divisor is changed so that the index remains unaffected. The individual Dow Jones averages basically include issues of large companies each having market capitalization of several billions if not hundreds of billions of US dollars. Therefore, mutual funds or trusts based on the Dow Jones Averages do not include small cap or micro cap stocks discussed below.
The Wilshire index family provides a good example of indexes that track the entire market and the individual market segments. Wilshire 5000® equity index is a market value weighted index that includes all NYSE and AMEX stocks and the most active stocks traded on NASDAQ (the total includes over 6,500 securities). The included issues are common stocks, REITs and limited partnerships, all of which are selected based on volume, institutional holdings, and conversion criteria. For a company with multiple classes of stock, all shares are combined into the primary issue's shares to reflect the total market capitalization of the company. The index measures the performance of all U.S. headquartered equity securities with readily available price data. Thus, the Wilshire 5000 index encompasses virtually all of the entire U.S. stock market.
The Wilshire 4500® equity index measures the performance of all small and mid cap stocks. This index includes the Wilshire 5000 securities with the companies in the Standard & Poor's 500 Index removed thus including over 6,000 stocks. The Wilshire 4500® equity index includes capitalization-weighted representation of the included stocks.
The Wilshire large cap 750 index measures stocks of large companies with market capitalization of more than about $5 billion (an approximate value also depending on the overall market conditions). This index is a subgroup of the Wilshire 5000 index because it represents a market capitalization-weighted portfolio of the 750 largest companies in the Wilshire 5000 index.
The Wilshire mid cap 500 index measures stocks of mid-sized companies with market capitalization of less than about $5 billion. This cap-weighted index is a combination of 500 relatively large and midsize stocks ranked based on market capitalization from 501 to 1,000 in the Wilshire 5000 index.
The Wilshire small cap 1750 index measures stocks of companies with market capitalization of less than about $1 billion. This index is comprised of the next 1,750 stocks ranked by market capitalization from 751 to 2,500 taken from the Wilshire 5000 index. The Wilshire micro cap index measures stocks of companies with market capitalization of less than about $350 million. This cap-weighted index includes all stocks in the bottom half of the Wilshire 5000 Index, that is, stocks below the capitalization ranking of 2,501.
There are also numerous other Wilshire indexes such as the Wilshire large value index, the Wilshire large growth index, the Wilshire mid cap value index, the Wilshire mid cap growth index, and other indexes. The Wilshire large value index measures large-cap stocks that exhibit value characteristics (e.g. low price to book ratio). The Wilshire large growth index measures large-cap stocks that exhibit growth characteristics (e.g. high price to book ratio). Periodically, the above indexes are modified or “rebalanced” by adding and removing stocks. The rebalancing enables the indexes to provide a better reflection of stock market activity and performance. That is, rebalancing is done in an effort to have growth stocks included in the growth index, etc. Furthermore, rebalancing ensures that changes in valuation or market cap are periodically updated. The corresponding mutual funds then change their portfolio based on the index rebalancing.
The Russell index family is another widely recognized example of indexes that track the entire market and the individual market segments. Russell 3000® Index measures the performance of the 3,000 largest U.S. companies based on their total market capitalization, which represents approximately 98% of the investable U.S. equity market by market capitalization. This index has a total market capitalization range of approximately $480 billion to $140 million (on Jul. 1, 2001, but values depend on the market conditions).
Russell 1000® Index measures the performance of the 1,000 largest companies in the Russell 3000® index, which represents approximately 92% of the total market capitalization of the Russell 3000® Index. The smallest company in the index has an approximate market capitalization of about $1.3 billion. Russell 2000® Index measures the performance of the 2,000 smallest companies in the Russell 3000® Index; this represents approximately 8% of the total market capitalization of the Russell 3000® Index. In July 2001, the average market capitalization of a stock in Russell 2000® Index was approximately $530 million and the median market capitalization was approximately $410 million. The largest company in the Russell 2000® Index had an approximate market capitalization of $1.4 billion.
There are also other Russell indexes. For example, Russell 200® Index measures the performance of the 200 largest companies in the Russell 1000® Index, which represents approximately 75% of the total market capitalization of the Russell 1000® Index. Russell Midcap® Index measures the performance of the 800 smallest companies in the Russell 1000 Index, which represent approximately 25% of the total market capitalization of the Russell 1000® Index. Russell 2500® Index measures the performance of the 2,500 smallest companies in the Russell 3000® Index, which represents approximately 17% of the total market capitalization of the Russell 3000® Index.
Russell Small Cap Completeness® Index measures the performance of the companies in the Russell 3000® Index excluding the companies in the Standard & Poor's 500 Index.
Since index funds like the Wilshire 5000® and Russell 3000 are market cap weighted, usually only 10%-15% or less of an investor's money is allocated into the smallest 90% companies ranked by market capitalization. The 100 largest stocks receive an allocation of above 50% of the total amount invested. Generally, investors in index funds have no meaningful exposure to micro cap, small cap or even some medium sized companies, and frequently no exposure to many small cap or micro cap companies since they are not components of they index funds own.
There are index funds that invest in micro cap, small cap and medium sized companies, but these funds have an inherent disadvantage. As a high performing stock grows, its rank increases. When a high performing stock “graduates” from the Wilshire micro cap index, it is added to the Wilshire small cap index. Similarly, when a high performing stock “graduates” from Russell 2000®, it is added into Russell 1000®. In this “rebalancing”, the high performing stock is “effectively sold” because its weighting in the new index is small compared to other members of the index. Moreover, when a stock graduates from Russell 2000® to Russell 1000®, investors in Russell 2000® no longer have any ownership interests of that particular security. Furthermore, in each index, only a small amount of money is allocated into the smaller components due to the disparity in market capitalization between the largest and smallest companies. Thus, in an index fund, an investor cannot effectively buy a meaningful amount of a micro cap or a small cap stock and “hold” the stock as is it grows and moves from one index to another. That is, in the above-described funds, an investor cannot fully take advantage of some high performing stocks by long-term ownership in a tax efficient way.
Actively managed, open-ended mutual funds generally dilute the impact of some of the best performing stocks because most active funds restrict the percentage weighting for an individual stock or sector. This too translates into effective selling of high performing stocks because they are not allowed to grow substantially in weight (increased ownership is artificially restricted) relative to the other stocks in the fund. To maintain investments in high performing companies, (i.e., allow nature to take its course) managers of open-end mutual funds would have to increase the dollar allocation into winning stocks as new money is invested into the fund in direct proportion to their existing relative weight to avoid dilution by new shareholders.
Frequently, most actively managed funds that specialize in investment in small or mid cap stocks sell the companies when they do well (e.g. their market cap exceeds a certain limit). Therefore, investors typically do not hold micro cap to medium sized stocks for a long enough period to “let the winners run”. Most investment managers (advisors) usually do not hold individual stock for long periods of time. The holding period of most stocks in “managed” funds tends to be significantly less than 3 years because investment advisors try to predict future performance of a stock and/or they sell any stocks that no longer fit their select criteria. Frequently, they sell stock of growing small companies that no longer have characteristics in accord with the fund's objectives. For example, company's market cap is too large or stock is no longer a “value” stock. Thus, actively managed funds do not provide a solution that ensures long-term ownership of the best performing micro cap to medium sized stocks. In turn, the investors do not accrue the benefit that derives form long-term ownership of micro cap, small cap, or mid cap stocks that grow to achieve appreciably larger market capitalization.
A portfolio of stocks may also be arranged in a unit trust that operates differently than a mutual fund. A unit investment trust issues securities that represent an undivided ownership interest in the portfolio of stocks held by the trust. (For example, there are publicly traded shares of the DIAMONDS Trust®, which holds all of the 30 common stocks of Dow Jones Industrial Average.) In a unit trust, a trustee issues creation units to anyone who deposits with the trustee a specified portfolio of the securities and a cash payment generally equal to accumulated dividends. In general, the investment trust only issues Creation Units in specified large-sized minimum numbers (for example for the DIAMONDS Trust it is 50,000 DIAMONDS or multiples thereof). A creation unit holder can, however, purchase and sell the units on the secondary trading market in lots of any size. The unit holders are paid regularly an amount corresponding to the amount of any cash dividends on the Trust's portfolio of securities during the applicable period (minus the fees and expenses associated with operation of the Trust).
Some types of unit investment trust are structured so that the units are not individually redeemable, and can be redeemed only by tendering to the Trust the entire amount of the creation units (i.e., the creation unit-sized minimum number) or a multiple thereof). Upon delivery of the creation units, the Trust delivers a portfolio of the underlying securities (together with a cash payment generally equal to accumulated dividends as of the date of redemption). The trust always maintains the correspondence between the composition and weightings of securities held by the trust and the stocks in the corresponding index. Specifically, the DIAMONDS Trust includes 30 common stocks that are included in the Dow Jones Industrial Average. These stocks are adjusted to conform to periodic changes in the identity of the Dow Jones Industrial Average. Importantly, each of these 30 stocks have a much larger market capitalization than any small cap or micro cap stock (or even most mid cap stocks).
There are other investment trusts that hold a stock portfolio of a particular industry, sector or group designed to provide a diversified exposure to the industry, sector or a group. For example, Merrill Lynch provides HOLDRs® that are trust-issued receipts representing a beneficial ownership of a specified group of stocks. The owner of a particular HOLDR owns a group of stocks as one asset, but can also unbundle the HOLDR any time to own each of the underlying stocks. The unbundled stocks can be traded individually to meet specific tax or investment goals. HOLDRs are taxed only on gains and income that the owner actually realizes. Thus, HOLDRs allow the owner to take tax losses in any individual stock that declines and allow the owner to defer capital gains indefinitely on the best performing stocks. Furthermore, HOLDRs have a buy-and-hold feature that limits taxes resulting from portfolio turnover.
The individual HOLDRs are exchange-traded and are priced just like any other stock to provide liquidity. The owner retains the voting and dividend rights on the underlying stocks. HOLDRs provide a relatively inexpensive way to own about 19 to 20 stocks. The owner doesn't pay management fees, but pays a transaction costs and an annual custody fee taken against cash dividends and distributions, when they are issued.
An example of a HOLDR trust is a Biotech HOLDR trust, which holds the following 20 stocks (with the approximate initial weighting provided in parentheses): Applied Biosystems Group (6.67%), Affymetrix Inc (2.02%), Alkermes Inc. (0.76%), Amgen Inc. (19.76%), Biogen Inc. (9.92%), Chiron Corp. (4.78%), Celera Genomics (0.77%), Genentech Inc. (18.29%), Enzon Inc. (0.93%), Genzyme Corp. (2.99%), Gilead Sciences Inc. (2.97%), Human Genome Sciences Inc. (1.77%), ICOS Corp (1.29%), IDEC Pharmaceuticals Corp. (2.49%), Immunex Corp. (8.9%), Medimmune Inc. (6.03%), Millennium Pharmaceuticals Inc. (2.35%), Qlt Inc (2.42%), Sepracor Inc. (2.68%), and Shire Pharmaceuticals Grp. (2.2%). Thus, the Biotech HOLDR trust holds midsize to large stocks (stocks above $1.5 billion to tens of billion). In short, each of the existing HOLDS provides a relatively limited diversification and do not enable systematic investment in micro cap, small cap, mid cap and large cap stocks across the entire market.
There are also other unit investment trusts. For example, Nike Securities L.P. creates periodically First Trust® portfolios that are unit investment trusts holding a fixed diversified portfolio of typically about 20 to 25 stocks in one industry or market sector. The individual closed-end trusts trade on public exchanges to provide daily liquidity. The trusts typically have a life of 13 months to 5 years. Investors invest a minimum of about $10,000 (usually corresponding to 100 units). At the end of the term, the investors can get securities “in kind” without incurring tax liability or can get the corresponding monetary value. The trustee does not rebalance or does not otherwise manage the trusts over its lifetime. The First Trust® portfolios hold generally large to medium size stocks typically purchased initially at an equal dollar amount of each security. Basically, each of the First Trust® portfolios provides a relatively limited diversification and does not enable systematic investment in small cap or micro cap stocks.
In summary, the above-described funds or trusts have at least some disadvantages. Most market cap weighted funds or trusts allocate most of the invested money in large or very large companies. Passive, open-end index funds allocate new money in direct proportion of the market cap of each company, as specified for the corresponding index. Thus, investors money is usually allocated in an overwhelming fashion to companies having large to extremely large market capitalization. These companies tend to be more mature (and thus frequently have lower earnings growth) or tend to have higher relative valuations (i.e., very “popular” companies) than some younger, smaller, less “popular” companies. As explained above, small cap and micro cap index funds “effectively” sell small stock of fast growing companies.
Actively managed funds also tend to allocate investors' money based upon narrow characteristics or on market capitalization and tend to have a high turnover ratio. They also do not hold small cap and micro cap companies for many years to let “the winners run.” These funds also tend to restrict the relative weighting of the individual stocks. Therefore, there is a need for methods, systems and investment products that enable systematic, long-term investing in various market sectors or segments including mid size, small cap, or micro cap companies.